When Networking Pays

11/15/2011 11:16 am EST


James Fink

Editor, Jim Fink's Options for Income and Stocks to Watch

Here is one stock that has seen its share of ups and downs, but has never stopped innovating and adapting, writes Jim Fink of Investing Daily.

Over the past year, I have written about computer-networking giant Cisco Systems (CSCO) three times:

  • in April to criticize the shutdown of the consumer flip video business
  • in May to warn that Cisco had further to fall
  • and in August to declare that Cisco’s stock had finally bottomed.

Now, here in November, I’m writing again to say that Cisco is back in growth mode.

The company’s first-quarter 2012 earnings report reflects a surprisingly quick turnaround in Cisco’s business fortunes. The company generated $11.26 billion in revenue, the most first-quarter revenue in its history.

Both earnings and revenues beat analyst estimates, with Cisco’s $1.78 billion in earnings blowing estimates away by 20.6%. The company has beaten analyst earnings estimates for five consecutive quarters, but this quarter’s 20.6% beat was much larger than the average 8.51% beat in previous quarters.

In the Cisco conference call, CEO John Chambers explained why the company was winning again:

Our strategy is working, we are capitalizing on the major generation shifts happening in IT. These include the consumerization of IT, movement to the cloud, everything mobile, business social network and pervasive video. We’re in the right spot at the right time.

These generation shifts lead to a convergence of both our products and of our customer segments, where no longer will enterprise and service provider and commercial and public sector be separate, where the products be separate from routing and switching in the data center and the end devices, you will see them all come together in an architecture-shared approach.

I think this last sentence is very important in understanding Cisco’s competitive strategy. Cisco wants to follow the Apple (AAPL) model of creating a proprietary architecture that encompasses all of a customer’s needs. As Harvard Business School professor Clayton Christensen wrote in The Innovator’s Solution: Creating and Sustaining Successful Growth:

Apple’s products employed a proprietary architecture involving extensive interdependence within the software and across the hardware-software interface.

In the early 1990s, customers began demanding to transfer graphics and spreadsheet files into word processing documents. This created a performance gap, flipping the industry to the not-good-enough side of the world where fitting interdependent pieces of the system together became competitively critical.

As Chambers said during the conference call, a corporation’s information technology (IT) back office is facing a “major generation shift” that involves combining many formerly disparate functions together (mobile, cloud, social network, video).

Cisco’s huge economies of scale and scope make it best able to provide the full system to customers. That is one of the major reasons why Cisco was able to take market share from both Hewlett-Packard (HPQ) and Juniper Networks (JNPR) during the first quarter.

Equally important to providing best-of-breed products and the servicing support needed to integrate these products is expense reduction. Cisco is cutting costs with laser-like focus to stem the decline in gross profit margins caused by competition-induced price discounting.

The sale of a Mexican manufacturing facility eliminated 8,400 employees, and Chambers says that another 6,500 employees will receive pink slips in 2012, reducing expenses by $1 billion. As CEO Chambers put it, the company had “a few too many inches around its waist” and has gone on a diet.

Cisco’s forward guidance on second-quarter revenue growth of between 7% and 8% and earnings per share (EPS) between 42 cents and 44 cents also beat analyst expectations for only 7% revenue growth and 42 cents in EPS.

The higher guidance was partly due to the fact that the company experienced a book-to-bill ratio of around 1.0 during the first quarter, which means that it received as many orders for future sales as it actually sold in Q1. In contrast, a year ago Cisco’s book of new orders ran 11% lower than actual sales.

Bottom line: Cisco’s business is improving and growth will be stronger going forward. With a “majority” of Cisco’s restructuring already completed and more than $44 billion in the bank (albeit mostly stuck overseas), I can say without hesitation that Cisco’s future looks much brighter than its recent past.

After Cisco’s earnings were released, many Wall Street analysts upped their price targets on the stock, including Citigroup (C), Deutsche Bank (DB) and Morgan Stanley (MS). With Cisco’s stock currently trading at $19.02, hitting those $21 or $22 price targets amounts to further price appreciation ranging from 10.4% to 15.7%.

That type of capital gain sure beats bond coupons. Count me in.

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